Tax exempt debt financing

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This article – the second of two written for GWI by the law firm, Cadwalader Wickersham & Taft – discusses the general rules relating to private activity bonds used to finance the construction, purchase or rehabilitation of water facilities in the US. By Robert Vitale, David Feeney and Ross Peters.

A number of US municipalities are actively considering how the private sector can best provide the technical and financial assistance required to upgrade, operate and maintain water and wastewater systems. One of the main obstacles to outsourcing these services is that many cities initially raised the capital to build water systems by issuing long term tax exempt bonds, or else cities are seeking to use tax exempt debt as a cheap form of financing to pay for the construction and renovation of such systems.

Without proper contract structuring, a municipality’s efforts to outsource tasks to a private operator could cause outstanding bonds to lose their tax exempt status as a result of the so-called private activity bond rules.

Since private activity bonds (other than “qualified private activity bonds”) do not enjoy tax exempt status, it is important that municipalities planning to use private companies to build, upgrade, or operate water or wastewater systems financed – or to be financed – with tax exempt debt avoid private activity bond treatment for that debt.

One common mechanism used by US municipalities to hire private contractors is the O&M contract. If the agreement in question satisfies certain requirements established for management, service or incentive payment contracts between a government person and a service provider, the service provider may service all, a portion of, or any function of, a qualifying facility.

Assuming that the parties have determined that a facility falls within section 103 of the Internal Revenue Code of 1986 (the “Code”), and the parties wish to preserve the tax exempt status of associated financing for that facility, they must navigate a series of Code-imposed rules when structuring contract terms, compensation arrangements, and rights and remedies provisions to avoid causing a related bond issuance to be classified as a private activity bond.

One of the critical issues is to ensure that no part of the operator’s compensation may be based on a share of net profits from the operation of the facility in question. However, this does not mean that a management contract cannot compensate the operator on an incentive basis to encourage it to minimise expenses or to maximise profits for the true owner of the facility (i.e., the municipality).

Stated simply, a private activity bond is any bond that falls foul of (i) the “private business use test” set forth in Section 141(b)(1) of the Code and the “private security or payment test” of Section 141(b)(2), or (ii) the “private loan financing test” of Code Section 141(c).

The private business use test
Several sections of the Code provide basic safe harbour concepts enabling the parties to structure a management contract that does not constitute unpermitted private business use of a facility. So, for example, a contract to provide for the operation of a facility that consists predominantly of public utility property generally does not give rise to private business use if the only compensation is the reimbursement of actual and direct expenses and reasonable administrative overheads of the operator. This is also the result if the only compensation is the reimbursement for actual and direct expenses paid by the operator to third parties.

Besides the Code itself, parties can also look for guidance in Revenue Procedure 97-13, which sets out guidelines for qualifying management contracts. Revenue Procedure 97-13 requires the operator’s compensation to be “reasonable” in the context of the services provided. Although a direct share (by the operator) in net profits is not allowed, it is permitted to provide for a productivity reward equal to a stated amount based on increases or decreases in gross revenues (or adjusted gross revenues), or reductions in total expenses in any annual period during the contract term.

Revenue Procedure 97-13 also safe harbours an arrangement under which at least 80% of the services for each annual period during the contract term are based on a periodic fixed fee (which may escalate over time). The only limit on the remaining 20% is that it cannot be based on a share of net profits. This Revenue Procedure also provides for limitations on the overall term of the management contract, such that the term of the contract, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the facility and 10 years, unless the facility consists predominantly of public utility property (as defined by Code Section 168(i)(10)), in which case the 10-year limit is extended to a 20-year one.

Private letter ruling 9823008
Private letter ruling 9823008 provides an example of a management contract that avoids private business use treatment. Although the ruling involved a management contract for a power project, its analysis of the relevant Code sections is instructive in seeking guidance on how similar contracts could be structured for water and wastewater facilities.

Moreover, this ruling illustrates how a contract which may otherwise appear to fail one, or more, of the applicable “private business use” criteria can still past muster (in the eyes of the IRS) if it survives the kind of “facts and circumstances” analysis often applied by the IRS in evaluating substance over form.

Private letter ruling 9823008 involved a management contract which required the operator to operate and maintain the facility, as well as undertake certain capital improvements that might become necessary due to changes in the law. After finding that the duration of the contract met the requirements of Revenue Procedure 97-13, the IRS reviewed the compensation provisions of the contract to determine if they too passed muster. The management contract provided for compensation to the operator based on the following five components including override provisions such that the sum of the items in (ii), (iii) and (iv) plus any cost overrun payments referred to below could not exceed 20% of the sum of the items in (i), (ii), (iii) and (iv) plus said cost overrun payments.

(i). A fixed direct fee. The operator was to receive a “fixed direct fee” equal to 90% of the annual direct cost budget for that year. This fee also included a management fee.

(ii) A variable payment. This aspect of the formula established a division of responsibility between the municipality and the operator for certain third party costs.

(iii) A cost incentive fee. In any contract year that the actual total costs were less than the total cost budget (stated to be the direct cost budget plus the third party budget), the operator was to be paid a cost incentive fee.

(iv) A non-cost performance incentive component. The operator would receive incentive payments for performance tied not to cost expenditures, but instead to other operational criteria such as system reliability, worker safety and customer service.

(v) A third party cost reimbursement component. The operator and the issuer municipality established a third party cost budget for each year, with an “end of year” true-up mechanism.

In addition, the contract compensated the operator for undertaking capital improvements, and other costs incurred on unforeseen events or changes in the intended scope of work, changes in the law, and changes in system policies or procedures. These categories were to be performed at cost of services, but cost saving incentives and disincentives were built-in for capital projects. Importantly, the contract specified that these payments were not linked in any fashion to the compensation payments above.

The IRS analysed the contract and found that the payment terms outlined in clauses (i) to (v) met the requirements of the Code because they did not give the operator a share in the net profits of the facility – even though they otherwise had incentive/disincentive characteristics tied to plant performance.

However, the IRS did scrutinise the payment provisions related to capital improvements and unforeseen events, holding that, as a technical matter, they caused the contract to fall outside of the specified safe harbour provisions. The IRS went on to note that notwithstanding this technical failure, the contract would not be held to result in private business use status, based on a facts and circumstances analysis.

Briefly put, the IRS determined that the nature of the compensation arrangements for construction oversight duties and unforeseen circumstances were either mostly in the nature of pass-through reimbursements or sufficiently unrelated to normal day-to-day duties so as to be properly excluded from calculations of the overall compensation to be paid for normal operation of the system.

Private security or payment test
If it is determined that private business use of a facility exists after applying the private business use tests, associated bonds are likely to be classified as private activity bonds unless the “private security or payment test” can be properly addressed.

Under the private security or payment test, private activity bond treatment can be avoided, if the aggregate amount of the private security portion and the private payment portion of the test does not exceed 10% of the proceeds of a bond issue.

The private security portion of the test takes into account whether payments of debt service on the proceeds of a bond issue are secured by an interest in (i) the property used for a private business use, or (ii) payments in respect of property used for a private business use (i.e. rental, loan or other payments from non-government users of the property). Thus, private security treatment results if “an interest in the [privately used] property or payments [related to the property] secures the payment of debt service on the bonds.”

The private payment portion of the test takes into account any part of the debt service that will be paid from payments, whether or not to the issuer, in respect of privately used property or borrowed money used or to be used for a private business use. Private payments include any payment that is made – directly or indirectly – by a non-government person and can be allocated to the property used by the paying person. Private payments are not taken into account to the extent of the issuer’s ordinary and necessary expenses that are “directly attributable to the operation and maintenance of the financed property used by” the payer.

Even if a bond issue is able to comply with the requirements of the private business use test and/or the private security or payment test, the bonds may still be classified as private activity bonds.

If the non-qualified amount of the bond issue exceeds $15 million, the bonds will be treated as private activity bonds, unless the issuer allocates a portion of the issuer’s volume cap applicable to qualified private activity bonds, to that portion of the non-qualified amount which exceeds $15 million and such portion of the bonds satisfies the criteria for qualified bond treatment.

The non-qualified amount is the lesser of (x) that part of the issue proceeds to be used for private business uses or (y) the aggregate of that part which is secured by property used for a private business use and that part which has interest or principal which will be paid from payments in respect of property used for a private business use.

Private loan financing test
Another obstacle that the issuer must avoid is that an issue will be classified as a private activity bond if more than 5% of the issue proceeds (or $5 million, whichever is less) is loaned to private borrowers or is used to finance loans to private borrowers.

In making this determination, the substance of the transaction is elevated over the form to determine the true use of the proceeds. Thus, a lease or other contractual arrangement (i.e. a management contract) may constitute a loan if the tax ownership of a water or wastewater facility is considered for tax purposes to be transferred to a private person.

A management contract with respect to a water or wastewater facility is not treated as a loan of proceeds, unless the agreement in substance shifts significant burdens and benefits of ownership to the non-government purchaser or manager of the facility.

Qualified private activity bonds
After determining that bonds are in fact private activity bonds, the question switches to whether they are qualified private activity bonds. Section 141(e) provides a list of qualified private activity bonds, including exempt facility bonds, which would be qualified if the state allocates a sufficient portion of its volume cap to the bonds.

Exempt facility bonds are in turn described in Section 142 of the Code to include bonds issued as part of an issue 95% or more of the net proceeds of which are to be used to provide facilities for the provision of water or wastewater services. Similarly, prior to 1986, industrial development bonds that were part of an issue, substantially all of whose proceeds were to be used for such purposes, qualified as tax exempt bonds.